States, Industry
In Oversight Flap

By

Jean Eaglesham

Updated Jan. 3, 2011 12:01 a.m. ET

States are getting ready to take over the regulation of thousands of investment advisers from federal agencies this summer in an effort to intensify scrutiny of the firms. But that oversight has costs that some cash-strapped states can't easily afford.

Securities regulators in states that will pick up the lion's share of the extra workload are battling to get funding for extra staff from local lawmakers who already are struggling with ballooning deficits.

The Dodd-Frank financial reform act requires a mass migration of midsize advisers to state from federal control. Regulation of 4,100 investment advisers, with $25 million to $100 million of assets under management, will transfer in July from the Securities and Exchange Commission to state regulators. The switch is designed to improve scrutiny of the midsize firms.

But the states' dire conditions have raised questions about how effective the regulatory overhaul will be in protecting consumers. That, in turn, has spawned a turf war between regulators.

The battle centers on whether investment advisers should be put under the control of an industry-funded national regulator or left to the states and the SEC. An SEC report on this option will be issued this month.

Data drawn from the latest "home state" registrations of the advisers show that a handful of states will bear the brunt of the new regulatory workload. Four states—California, Florida, New York and Texas—will account for 35% of all the firms switching over, according to analysis by National Regulatory Services, a Connecticut consulting firm.

Multibillion-dollar budget deficits in each of these four states cast a funding shadow over preparations for the impending increase in their regulatory workload.

California expects the number of investment advisers it will regulate to increase to about 3,800 this summer from 3,070 now. The state has just eight full-time staff dedicated to registering and examining investment advisers.

Its request for extra resources is subject to the overall state-budget process, at a time of big cutbacks.

"There are challenges definitely. Since we're self-funded and dealing with issues of good governance and federal mandates, we're usually treated fairly with our budget requests, but it's all part of the process," said
Mark Leyes,
a spokesman for California's Department of Corporations.

In Florida, the number of advisers overseen by 75 full-time staff is expected to increase to 1,800 from 1,100 under the Dodd-Frank change. "We have asked for additional positions," said
Amy Alexander,
deputy director of communications at the Florida Office of Financial Regulation. "We do not know whether new positions will be approved."

New York has no regular examination program for the more than 1,500 advisers it oversees, relying instead on its extensive statutory powers under the Martin Act to punish misconduct if problems emerge. The New York attorney general's office declined to comment on its plans to oversee the new firms coming under its purview.

State regulators are adamant that financial pressures won't mean the new firms escape scrutiny. "We'll handle the shift regardless of whether we get the extra funding we've requested," said
Robert Elder,
head of communications at the Texas State Securities Board.

The state, which expects the number of investment advisers it regulates to double to about 2,400 from 1,200, has had a request for an extra 10 staff approved. The money to fund the extra staff hasn't been released.

State regulators say investment advisers will face much greater scrutiny following the switch. Through September 2010, the SEC examined just 9% of the 11,888 investment advisers it currently regulates.

"There are about 3,000 investment advisers that have never been examined by the SEC, and these firms will go to the top of the state examination priority list," said
Robert Webster,
director of communications at the North American Securities Administrators Association, a group representing state regulators. NASAA said it is "confident" that state securities regulators will marshall the resources needed for their new role.

Some think increased state scrutiny could produce a burst of enforcement activity. "These midsized firms are moving from being little fish in the world of federal scrutiny to very big fish in the arena of state enforcement," said
John Gebauer,
managing director of consultants NRS.

Others say more needs to be done to improve regulation in this area.

The Financial Industry Regulatory Authority, the industry-funded watchdog for broker-dealers, has urged the SEC to recommend a similar industry-funded regulator for investment advisers. Finra has suggested how it would approach the task if it were handed this role.

The trade body asserted in a letter to the SEC that "the states are not adequately prepared to take on the inspection, examination and enforcement role assigned to them under the Dodd-Frank Act."

Other industry bodies, as well as the state regulators, are staunchly opposed to Finra expanding its empire in this way.

The Investment Adviser Association, which represents SEC-registered advisers, opposes the move because of Finra's "lack of transparency and accountability and its poor track record on enforcement, as well as its bias favoring the broker-dealer model,"
David Tittsworth,
executive director, said in an interview.

Finra rejects such criticism.
Richard Ketchum,
Finra's chief executive, says the regulator already acts on "red flags" it spots among investment advisers at the broker dealers it regulates. He cited the criticism leveled at Finra for failing—along with the SEC—to uncover the multibillion-dollar Madoff fraud after conducting examinations at Bernard Madoff's firm.

"Some organizations that attacked us for not finding Madoff somehow are appalled by the fact that when we see red flags we will follow them," Mr. Ketchum said.

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